A PILLAR TO LEAN ON: AUSTRALIA’S APPROACH TO IRRBB HOLDS VALUABLE LESSONS FOR GLOBAL BANKS

PRACTICES IN MANAGING THE INTEREST RATE RISK IN THE BANKING BOOK (IRRBB) REQUIREMENTS

Managing interest rate risks, a challenge for banks and financial institutions at the best of times, has taken on a fresh urgency amid the novel coronavirus (Covid-19)¹ outbreak. Recognising the unprecedented threat the disease’s spread poses to their respective economies and markets, most central banks around the world have slashed interest rates in a bid to boost liquidity in the financial markets to support economic growth.

This globally coordinated action provides a stark yet appropriate backdrop to discuss the relative merits of the two main approaches adopted by banks and their regulators to the Basel Committee’s regulatory framework for managing interest rate risk in the banking book (IRRBB).²

Additionally, ongoing consultations by the Australian Prudential Regulation Authority (APRA)³ – whose approach to IRRBB stands apart from other regulators worldwide and has proven successful in helping Australian banks manage risk efficiently - have the potential to influence the global capital requirement standards set forth by the Basel Committee on Banking Supervision (BCBS), and bring about changes to regulatory approaches across markets around the world.

THE IRRBB ETHOS

The IRRBB framework, originally introduced in 2004 and revised by BCBS in 2016, aims to ensure banks have sufficient capital to absorb or withstand the risks arising from their exposure to interest rate movements in the banking book positions. It does so by defining the various sources of interest rate risks; identifying the assets and liabilities on a bank’s balance sheet that can be subject to these risks; and, prescribing ways to measure the risks with two specific metrics.

The risks that the IRRBB framework is designed to assess and manage include repricing risk or gap risk, yield curve risk, optionality risk and basis risk.⁴ The key measure that helps in this exercise is the change in Economic Value of Equity (EVE), which focuses on the risk to net worth arising from all repricing mismatches and other interest rate sensitive positions over the long term. The other measure is the change to Net Interest Income (NII), which is measured by the changes in Net Interest Income or margin, and focuses on the impact of changes in interest rates on accrual or reported earnings in the near term.

FIGURE 1:

IRRBB Regulations Across Key Jurisdictions

_{Source: APS 117 – Current Consultation, Basel Standard 368 – IRRBB – April 2016, MAS, HKMA, IRB – Internal Rating Based Approach; ADI – Authorised Deposit-Taking Institution;}

_{EVE– Economic Value of Equity; NII – Net Interest Income; IR – Interest Rate; AIRO – Automatic Interest Rate Options;}

While most regulators around the world have adopted these metrics to manage the capability of their banks to cope with interest rate volatility, their approaches to following the Basel Committee guidelines - categorised as Pillar 1 or Pillar 2 - have diverged.

The Pillar 1 approach requires banks to reserve capital by adopting the agreed approach prescribed by the regulator. In doing so, it seeks to harmonise the variations with a pre-determined approach – which considers each bank’s exposure - that specifies the amount a bank has to hold as reserve capital. For such banks, the total Risk Weighted Assets (RWA) includes a portion that is calculated to account specifically for IRRRB risks.

The Pillar 2 approach, on the other hand, sets the broad principles and allows banks to follow a set of internal measures, where banks do not need to reserve IRRBB capital in the Pillar 1 RWA requirements. Thus, the Pillar 2 approach relies on banks to calculate the IRBB capital they need based on their in-house management practices and processes, with periodic checks by the regulator to ensure sufficient capital is maintained against the banks’ internal thresholds.

PICKING THE RIGHT APPROACH

Currently, APRA is the only regulator to adopt the Pillar 1 approach for IRRBB. APRA’s decision was driven by its finding that IRRBB risk was significant for Australian banks and yet they were allowed to use their internal models to gauge their Banking Book interest rate risk exposures and not to reserve capital for these exposures.

As a result, major Australian banks have prescribed RWA requirements coming from their Banking Book interest rate exposures, prompting them to actively manage their RWA or capital requirements. Further, these measures are disclosed to the markets every quarter.

While the Basel Committee concluded that the Pillar 2 approach would be better suited to capture the diffuse nature of IRRBB,⁵ the performance of Australian banks can be viewed as a vindication of APRA’s decision to adopt the Pillar 1 approach.

With their upgraded risk models, the country’s banks have succeeded in managing their exposure to risk, in return saving millions of dollars in capital requirements.

For the quarter ending March 2019, while ANZ cited lower exposure to yield curve risk and repricing as drivers of a reduced IRRBB charge, National Australia Bank (NAB) reduced its IRRBB RWA by 22% y-o-y while Westpac slashed IRRBB RWA by 45% y-o-y. Commonwealth Bank of Australia (CBA) achieved the greatest savings of the Big Four Australian banks, achieving a 54% y-o-y reduction in IRRBB RWA.⁶

These outcomes highlight the effectiveness of mandating explicit capital requirements as espoused by the Pillar 1 approach, and its ability to inspire greater discipline and active management of IRRBB compared to the more opaque nature of the Pillar 2 approach.

FIGURE 2:

IRRBB RWA Movement of Australian Major Banks

_{Source: Company financial reports}

TOOLS OF THE TRADE

Banks typically turn to a range of structural as well as derivative tools to manage IRRBB, with certain tools being best suited to manage a particular type of risk. For instance, linear derivatives such as interest rate swaps, futures and foreign exchange swaps are geared towards reducing basis risks as well as gap risks, which tend to be the most common type of IRRBB. Non-linear derivatives, such as interest rate options and swaptions, can be used to effectively manage optionality and behaviour risks.

While banks across the Asia Pacific (APAC) region rely more on structural tools, Australian banks are known to consider a combination of both structural as well as derivatives tools. Indeed, derivatives form a major part of the arsenal used by the country’s authorised deposit-taking institutions (ADIs) to manage interest rate risk with interest rate swaps and futures, making up a bulk of the mix. Futures are a common approach to hedging the bulk of interest rate risk as they are very liquid. Another significant management tool – especially when banks are raising funding – is the crosscurrency interest rate swap.

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WITH THEIR UPGRADED RISK MODELS, THE COUNTRY’S BANKS HAVE SUCCEEDED IN MANAGING THEIR EXPOSURE TO RISK, IN RETURN SAVING MILLIONS OF DOLLARS IN CAPITAL REQUIREMENTS.

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